The 401(k): Traditional versus Roth
Since 1997, Roth IRA accounts have been around as an investment vehicle. In the past several years, participants at many work places have been offered the opportunity to do a Roth 401(k).
The Roth 401(k) follows many of the same rules as your current Traditional 401(k), but there are two very large distinctions between doing a Traditional 401(k) and a Roth 401(k):
- 1.) How contributions are taxed: In a traditional 401(k) plan, all of your contributions will be put in your plan on a pre-tax basis. Thus, your reportable W-2 income at year end will be lowered by the amount of Traditional 401(k) contributions that you make over the course of the year. In a Roth 401(k), your contributions will be taxed now and put in your plan on an after-tax basis. Thus, you will have no change in your reportable W-2 income.
- 2.) How distributions are taxed: Eventually, money will have to come out of your 401(k) plan. In the Traditional 401(k) plan, all of your distributions will be taxed at whatever your ordinary income rate will be at the time of distribution. Many participants think that their ordinary income tax rate will be lower when they receive distributions down the road which is why they choose the Traditional 401(k) plan. However, in a Roth 401(k) plan, your distributions will be received tax-free at the time you take the distributions from your Roth 401(k) plan. If you believe that your ordinary income tax rates may be higher than the rates you pay today, than the Roth 401(k) would make more sense.
Both the Traditional and Roth 401(k) plans grow on a tax-deferred basis. This means that dividends, interest, etc. will all accrue without you paying any taxes while they grow in your account. Your Roth 401(k) can be directly rolled into a Roth IRA if you leave your employer down the road.
Picking the Right 401(k)Whether to do the Traditional 401(k), the Roth 401(k), or perhaps a combination of both will really depend on your overall tax situation. When making the decision, you need to:
- Consider that while your personal income may be lower in the future, the deductions you take on your tax return may be lower as well such as home mortgage interest.
- Think about where the tax environment may be given our own federal deficit in the United States. Obviously, most people planning for retirement don’t expect to lessen their standard of living, so do you really believe you will have a lower income?
Over the years, I have become a bigger fan of building differently taxed buckets with your investments so you can gain more control come distribution time. One consideration would be to max out the Traditional 401(k) to the match (if your company offers one), and then put the remainder into the Roth 401(k). This way you have both taxable and tax-free money down the road at retirement.
Is a Roth 401(k) right for you? If you like the idea of getting your tax bill done now and not having to pay tax again on that money it certainly is a great place to start.